Ludovica Ambrosino, Jenny Chan and Silvana Tenreyro
Current technological advances increase an vital query for policymakers: will increased productiveness result in disinflationary or inflationary strain? A coming wave of AI-driven productiveness development is usually described as a disinflationary tailwind that might permit central banks to carry rates of interest decrease with out reigniting inflationary pressures. But sooner productiveness development can simply as plausibly name for increased, not decrease, rates of interest. By elevating anticipated future earnings and the returns to funding, it stimulates consumption and funding as we speak, pushing up the pure charge of curiosity. Neither view is solely flawed and our mannequin reconciles the 2 by exhibiting that the reply relies on the timing, permanence, and sectoral origin of the productiveness shock.
The instinct that producing extra output from the identical inputs ought to decrease costs is a partial equilibrium argument, because it describes how productiveness impacts provide whereas holding demand mounted. Normally equilibrium, increased anticipated earnings and returns additionally increase consumption and funding. Whether or not inflation rises or falls subsequently relies on the stability between increasing provide and demand, and, crucially, on how financial coverage responds.
Methodology
For instance these dynamics, we analyse three situations for the way a ten% rise in productiveness can unfold: a brief enhance, a one-time and everlasting enhance, and a gradual and everlasting enhance (Ambrosino et al (2026)). All three situations seize the partial equilibrium instinct that increased productiveness permits companies to supply extra output per unit of enter. Every state of affairs steadily builds up the demand-side impact to indicate how the general affect on inflation relies on the interplay between provide, demand and expectations. The sectoral incidence of the shock may also matter: we start by discussing the implications of upper productiveness within the companies sector, earlier than contemplating the identical three situations within the tradables sector.
We seize these dynamics in a small open-economy New Keynesian mannequin with two sectors: a non-tradable sector, or ‘companies’ sector, whose outputs are priced and bought solely at dwelling (akin to haircuts or restaurant meals), and a tradable sector, whose items are traded internationally and priced with regards to world costs. Households eat each kinds of items, save, and provide labour. Corporations in every sector rent employees and capital and modify costs in order that inflation relies on each present prices and expectations of the longer term. A central financial institution units rates of interest in response to inflation
When increased productiveness quickly lowers inflation
We begin with a textbook instance: a brief enhance within the degree of productiveness (Chart 1, Column 1). Take into account a brand new know-how that enables companies to supply extra effectively. Manufacturing prices fall, and companies can provide extra items and companies. Early proof means that this sample could also be taking place in hiring for AI-exposed occupations. This enhance in provide locations downward strain on costs. On this state of affairs, the productiveness shock causes a brief fall in inflation as a result of it results in a one-off adjustment within the worth degree somewhat than a everlasting discount within the inflation charge. As soon as the shock dissipates, inflation returns to its steady-state degree. The pure actual charge of curiosity additionally falls quickly, earlier than recovering alongside inflation because the shock fades.
When increased productiveness will increase demand
The demand-side impact is stronger if the rise in productiveness is everlasting somewhat than non permanent. If know-how completely raises the economic system’s productive capability, households and companies count on increased earnings and earnings sooner or later. These expectations can have an effect on behaviour as we speak. Households might enhance consumption as a result of they count on future earnings to be increased, whereas companies might enhance funding as a result of the anticipated return to capital rises as productiveness will increase. Because of this, combination demand begins to extend alongside the enlargement in provide. Enterprise funding and family spending each transfer forward of realised productiveness beneficial properties, as many argue is occurring now with funding in AI infrastructure. This sample can be seen in how AI-related earnings information strikes fairness and bond markets.
These two forces might offset one another. Increased productiveness expands provide, whereas increased anticipated earnings raises demand. Whether or not inflation rises or falls subsequently relies on the relative energy of those two results. If the enlargement in productive capability dominates, inflation falls. But when demand responds strongly, the impact of upper productiveness will be much less disinflationary and even impartial for inflation (Chart 1, Column 2). The pure actual charge of curiosity is little modified on this state of affairs, reflecting how intently the enlargement in provide and the strengthening in demand offset each other.
When increased productiveness is inflationary
As an alternative of a direct enhance in productiveness, contemplate a state of affairs the place productiveness will increase steadily over time (Chart 1, Column 3). This sample is believable if common goal applied sciences diffuse slowly by the economic system. For instance, companies might must reorganise manufacturing, complementary improvements should be developed, or bottlenecks in expertise or infrastructure might sluggish adoption. Because of this, productiveness beneficial properties materialise solely steadily over time. Historic examples of general-purpose applied sciences, akin to electrical energy and data know-how, present the same sample: productiveness beneficial properties materialised over a few years as purposes developed and companies reorganised across the new know-how. Early UK trade information means that this sample could also be beginning to repeat.
Once more, if households and companies count on productiveness to rise sooner or later, they anticipate increased future incomes and earnings, which adjustments behaviour as we speak. They could begin spending and investing earlier than these beneficial properties really materialise. Corporations might make investments extra to benefit from increased anticipated returns, whereas households can enhance consumption as a result of they count on increased future earnings. This enhance in funding and consumption raises general demand.
This creates a state of affairs the place demand rises first whereas provide takes time to catch up. If demand grows sooner than provide, inflationary pressures can emerge. This enhance in demand exhibits up as a better pure actual charge, which requires financial coverage to tighten so as to dampen inflationary pressures (Chart 1, Column 3). This dynamic isn’t just theoretical. Comparable debates occurred through the know-how increase of the late Nineteen Nineties: sturdy productiveness development initially coincided with low inflation, prompting then-Federal Reserve Chair Alan Greenspan to argue that productiveness beneficial properties have been holding down inflation (Greenspan (1999)). However in the identical speech, Greenspan additionally warned that rising fairness costs and wealth results have been fuelling home demand and tightening labour markets sooner than productiveness beneficial properties may offset, and that wages would ultimately outpace productiveness, resulting in inflationary pressures. That is broadly what occurred: demand stored outpacing provide and the Federal Reserve raised rates of interest as inflation rose steadily till the 2001 recession (Furman (2026)).
Chart 1: 10% enhance in service productiveness
Notes: This chart exhibits the responses of assorted macroeconomic variables following a ten% productiveness shock within the companies sector, below three timing assumptions. The trade charge is outlined because the domestic-currency worth of overseas foreign money, so a decline corresponds to an appreciation of the home foreign money (an increase corresponds to a depreciation).
The place productiveness beneficial properties occur issues
Up to now, these situations have described a productiveness achieve within the companies (non-tradable) sector. Nonetheless, the inflationary penalties additionally rely upon the place productiveness beneficial properties materialise.
In our mannequin, costs for internationally-traded items are pinned down largely by world costs, so a productiveness achieve within the tradable sector doesn’t present up primarily as decrease costs for tradable items. As an alternative, the adjustment occurs by increased wages and earnings, which increase demand for companies, a sector the place provide can not develop as rapidly. The ensuing rise in companies costs can dominate, so combination inflation rises despite the fact that productiveness has improved. That is the basic Balassa-Samuelson mechanism (Balassa (1964) and Samuelson (1964)), utilized to the timing of a tradable-sector productiveness achieve.
The sectoral incidence of a shock can reverse the sample described above. A front-loaded productiveness achieve is disinflationary when it occurs in companies, however inflationary when it occurs in tradables, as a result of it results in demand-driven companies inflation somewhat than a fall within the tradable sector’s personal prices (Chart 2, Column 2). A gradual productiveness achieve yields the alternative sample: whereas this had been inflationary when the productiveness elevated in companies, it’s now disinflationary when the productiveness shock happens in tradables (Chart 2, Column 3). On this case, the trade charge appreciates in anticipation of the longer term productiveness achieve extra rapidly than home sources will be reallocated, inserting downward strain on imported and tradable items costs instantly (Broadbent et al (2024)).
Chart 2: 10% enhance in tradables productiveness
Notes: This chart exhibits the responses of assorted macroeconomic variables following a ten% tradable-sector productiveness shock, below the identical three timing assumptions. The trade charge is outlined because the domestic-currency worth of overseas foreign money, so a decline corresponds to an appreciation of the home foreign money (an increase corresponds to a depreciation).
Coverage implications
For central banks, increased productiveness is neither inherently inflationary not disinflationary. The inflationary penalties are a priori ambiguous as a result of productiveness impacts each provide and demand. The general affect relies on how rapidly productive capability expands relative to demand, whether or not the shock displays a brief degree impact or a persistent enhance in development, how expectations have an effect on spending and funding, the place productiveness beneficial properties happen throughout sectors, and whether or not financial coverage adjusts consistent with adjustments within the pure charge of curiosity. The duty for policymakers is subsequently to evaluate in actual time, whether or not productiveness beneficial properties are producing demand pressures and shifting the pure charge of curiosity, whereas trying by non permanent relative worth actions that don’t have an effect on medium-term inflation dynamics.
Ludovica Ambrosino is a PhD pupil at London Enterprise Faculty, Jenny Chan works within the Financial institution’s Exterior MPC Unit and Silvana Tenreyro is the James E. Meade Professor of Economics on the LSE.
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